CH 8, 9, 10, EXCAHGE RATE RISK EXPOSURES AND MANAGEMENT
* Exchange Rate Risk Relevant? If the world markets were “perfect” (no transactions costs, all
information available to everyone, etc) and “efficient” (prices adjust rapidly to reflect true
values), the exchange rate risks might not be relevant to the extent that 1) other prices (prices of
goods and services, interest rates, etc) may adjust rapidly to undo any impacts from exchange
rate changes (recall all the parity conditions), 2) individuals and corporations can use available
hedging tools or diversify their portfolios to minimize the impact. However, to the extent that the
world markets may not be perfect, exchange rate risk is real and relevant.
* 3 Types of Exchange Rate Risk Exposures
1) Transactions Exposure – HC value of a contractual cash flow (A/R, A/P, etc) denominated in a
FC may vary
- “Net” cash flows
2) Economic (Operational) – the value of the firm may be affected as the business (buying, selling,
and business operation) may be affected. We need to know firm’s operation, market conditions,
competition, etc to be able to assess this risk.
- Economic exposure of a purely domestic firm may also be affected. How? The business may
not be affected directly, but its business partners or competitors can be affected. In other words, the
business may be affected indirectly.
- Measuring Economic Exposure – difficult!
3) Translation (Accounting) – arises when the MNC consolidates financial statements of all of its
operations (HQs, subsidiaries, and affiliates) – historical vs. current exchange rates
- Does it matter? Cosmetic?
- Determinants of Translation Exposure
- Accounting Methods by International Accounting Standards Board,
a. Current/non-current, b. Monetary/non-monetary, c. Temporal, d. Current rate
- FASB 8 vs FASB 52 (2 sets of financial statements, one in HC and the other in a functional
currency)
* MANAGING TRANSACTION EXPOSURE
* A US firm has a SF 25 millon receivable in two months. So = $.63, E(S1) = $.64, F=$.64, US
interest rate is 5% APR, Swiss interest rate is 4% APR, option premium (cents per unit) = 0.15
for K=$.67 and 0.30 for K=$.68
(Hint: 5%=>.83%, 4%=>.67%, op pm=$.0015)
1. UH: $16m - FV, Uncertain
2. FH: $16m – FV, Certain
3. MMH: SF 24.83m, PV=$15.64m, FV=$15.77m
Note: CIRP and MMH & FH
4. Currency Option Hedge: 400 put contracts, $75k option premium for K=$.68 and $37.5k for
K=$.67,
Guaranteed $ receipt = $16.75m vs $17m, with net (in FV) $16,712,188 vs $16,924,377.50
- Option value determinants: So, volatility, time to maturity, interest rate, exercise price
5. Futures:
* Other Hedging Techniques
6. Risk Shifting and Pricing Decision – Price sales in home currency (e.g., $ invoicing)
7. Hedging via lead or lag – pay or collect early or late.
8. Exposure Netting – Portfolio approach, “Net” offsetting exposure in one currency with
exposures in the same or other currency. Lufthansa example. This includes Cross-Hedging and
Currency Diversification
9. Currency Risk Sharing based on a formula
10. Currency Swap and Parallel Loan
* Limitations of Hedging
1. Contingent Exposure (Potential) Exposure – FC denominated transaction is not certain and
contingent on a future event. Example: comparing alternative hedging techniques for GE
bidding on a hydroelectric project in Canada. If accepted, GE gets an A/R of CD$ 100m.
2. Over-hedging – example
3. Limitation of Repeated Short-Term Exposure
* Hedging Long-Term Transaction Exposure
1. Long-Term Forward Contract
2. Currency Swap
3. Parallel Loan
* Examples of transaction exposure and management
1. Your brewery produces Lusty Lite, a very-low-calorie, almost tasteless beer that has not yet
developed a following. In mid-March you receive an order for 10,000 cartons from Munich,
Germany, for next fall's Oktoberfest, with payment of 384,000 euro due in mid-September. In
your opinion the euro will rise from its present rate of e 1.006/$ to e 1.005/$ by September. You
can borrow marks for six months at 6% per annum. What should you do? Discuss issues as
necessary.
2. Whitfield Corporation is completing a new factory building in Yorkshire, England, and must
make a final construction payment of £8,000,000 in six months. Foreign exchange and interest
rate quotations are as follows.
Present spot rate
$1.80/£
Six-month forward rate
1.79/£
British six-month interest rate
8.00% per annum
U.S. six-month interest rate
7.00% per annum
The financial manager's own analysis suggests that in six months the following spot rates can be
expected.
Highest expected rate
$1.80/£
Most likely rate
$1.78/£
Lowest expected rate
$1.77/£
What alternatives are available for making payment, and what are the advantages or
disadvantages of each?
3. Ithaca Tool Company has received an order from a Malaysian manufacturing company for
machinery worth M$480,000. (M$ stands for Malaysian ringgits.) The export sale would be
denominated in Malaysian ringgits on a one-year open account basis.
The current spot rate is M$2.00/US$, and the forward ringgit sells at a discount of 10% per
annum. The finance staff of Ithaca Tool Company forecasts that the ringgit will drop 8% in
value over the next year. Ithaca Tool Company faces the following alternatives.
a. Wait one year to receive M$480,000 and then sell the ringgits received for dollars in the spot
market.
b. Sell the ringgit proceeds of the sale forward today.
c. Borrow ringgits from Public Bank in Kuala Lumpur at 15% per annum against the expected
future receipts of ringgits.
What do you recommend and why?
4. You have just purchased a deluxe Lamborghini sports car to be delivered to you in Italy three
months from today. The purchase price is 90,000 euro to be paid in cash at that time.
You have enough dollars in the bank in the United States to pay cash for the car. These dollars
are earning interest at 3% per annum, compounded monthly. Banco di Napoli offers 8% per
annum interest on three-month time deposits, no compounding.
You want to avoid all foreign exchange risk because foreign exchange markets have been
unusually volatile in recent months. The current spot rate is e 1.002/$ and the current threemonth forward rate is e 1.003/$.
How should you plan to pay for your Lamborghini?
5. Tay Enterprises of Los Angeles has just sold merchandise for 250,000 euro to a customer in
Germany, with payment due in euro three months from today. Tay Enterprises can borrow for
three months from a bank in Los Angeles at 5% per annum, or from a bank in Germany at 7.5%
per annum. Today's spot rate (direct basis) is $1.004/e. Three-month option contracts are
available with the following characteristics.
Contract size
Strike price
Option premium, per option
125,000 euro
$1.005/e
$200
a. Assume that you in fact hedged the transaction by the use of option contracts. On the day the
option matures, three months from now, the spot exchange is $1.005/e. Would you exercise the
option at that time or sell euro in the spot market? Why, and what is the dollar advantage of one
choice over the other?
b. What would have been your dollar sales proceeds, three months hence, if you had hedged via
the money market?
c. Given today's interest rates, what should be the three-month forward exchange rate for euro?
d. Given this forward exchange rate, what would have been your dollar sales proceeds had you
hedged via the forward market?
e. Given the choice, would you prefer a forward hedge or a money market hedge? Why, and
what is the dollar advantage of one choice over the other?
6. Korean Airlines (KAL) has just signed a contract with Boeing to purchase two new jet aircraft
for a total of $60,000,000, with payment, due three months from today. KAL currently has
excess cash of 50,000,000,000 won in a Seoul bank, and it is from these funds that KAL plans to
make its next payment.
Spot rate
Three-month forward rate
1200 won/$
1179 won/$
Korean three-month interest rate
5% per annum
U.S. three-month interest rate
4% per annum
These are the only rates available to KAL for either borrowing or investing.
A three-month call option in the over-the-counter (bank) market at a strike price of 1189
won/$ sells at a premium of 0.5% payable at the time the option is purchased.
KAL's foreign exchange advisor forecasts the spot rate in three months to be 1192 won/$.
How should KAL plan to make the second payment to McDonnell Douglas if KAL's goal is to
maximize the amount of won cash left in the bank at the end of three months? That is, how
much in won would be left under each possible alternative? Which alternative do you
recommend, and why?